With the United States and China at loggerheads over trade, investors should be aware of the many economic ties binding the two countries. Bank of America, U.S. Trust has released a new report that explores some of the finer points of U.S.-Sino relations and the strategic, but little understood, competitive advantages for corporate America.
The seven factors described below underscore the dynamism and competitiveness of U.S. companies and may help explain the resilience of U.S. large cap stocks despite ratcheting trade tensions between the U.S. and China.
U.S.-China Checklist: Understanding Some of the Finer Points of U.S.-Sino Trade
With the United States and China at loggerheads over trade, and with a recent report from AmCham China indicating that trade tensions are hurting the businesses of U.S. firms operating in China, we thought it would be an opportune time to shine additional light on some of the finer points of U.S.-Sino relations.1
Before delving into specifics, we continue to believe that U.S.-Sino trade tensions will remain a market irritant over the near term. On the plus side, a full blown trade “war“appears unlikely; however, some damage has already been done—bi-lateral trade tensions have contributed to softer growth in China this year and a bear market in Chinese equities. Thus far, most of the pain emanating from the trade spate has been borne by China, as exhibited by its weaker equity performance this year-to-date (Exhibit 1). But the U.S. is hardly immune, as the following makes clear.
Things for investors to consider:
One, U.S. investment in China is not as large as most think.
China, so goes the consensus, has become the “factory to the world,” leaving U.S. workers to flip hamburgers at low wages. Reality is quite different. U.S. foreign direct investment (FDI) into China has climbed during the past decade, but a little perspective is in order. The $79 billion the U.S. sank into China between 2000 and Q1 2018 equated to only 1.8% of total U.S. FDI flows to the world in the same period.2 U.S. FDI to Ireland, a country slightly larger than West Virginia, was over five times that to China in the same period. On a historic cost basis, China accounts for only 1.8% of total U.S. foreign investment. Translation: China has not attracted as much U.S. investment, absolutely or relatively, as is popularly portrayed.
Two, when it comes to foreign investment, the United States enjoys a huge lead over China.
It is no secret that Chinese investors are keen on increasing their direct investment position in corporate America. Next to America’s massive trade deficit with the mainland, China’s foreign investment in the United States has emerged as a key tension point between the two parties.
When it comes to FDI, however, America enjoys an overwhelming advantage—the U.S. corporate presence in China is orders of magnitude larger than China’s presence in the United States. In 2017, U.S. foreign investment in China (on a historic cost basis) totaled $107.6 billion, while China’s investment stake in the U.S. was just $39.5 billion—the latter was a fraction (37%) of the former. In other words, setting aside trade for the moment, U.S. firms enjoy greater access to the Chinese market than their Chinese counterparts do to the United States. This investment gap represents a strategic but little understood competitive advantage for corporate America.
Three, consumers are what U.S. firms are really after in China.
Contrary to popular opinion, access to the Chinese consumer—not workers—remains a key motivation for U.S. firms entering China. Keep in mind that China is not a unified market of 1.4 billion people, but a collection of markets with different dialects, varying levels of development and disparate per capita incomes. These variables, along with the brand sensitivity of Chinese consumers, intense foreign and local competition, and many other factors, dictate that American firms adapt to local tastes and operate on the ground. In China, customer proximity is key.
Accordingly, based on the latest figures provided by the Bureau of Economic Analysis (BEA), 83% of total sales by U.S. majority-owned foreign affiliates in China in 2016 (the last year of available data) went to the local market—substantially more than the global norm of 59%. Only 5.9% of U.S. foreign affiliate sales in China were for export to the U.S.
Fourth, what "Made in China" really means.
The mainland has emerged as an exporting powerhouse, with “Made in China” the most ubiquitous signature in the world. That said, lost on many folks is that a great deal of what China exports to the United States and the world are goods from so-called “foreign-invested enterprises”—not Chinese companies, but subsidiaries of global multinationals.
The contribution of foreign-invested enterprises to China’s export ascendancy is nothing short of staggering. From 1985 through 2017, aggregate exports of foreign-invested enterprises grew from about 1% of China’s total exports to more than 40%. And the share of exports to the U.S. coming from foreign-invested enterprises in China is even larger, estimated to be 60%.3 Because of this surge, “Made in China” does not mean what most people think. Thousands of low-cost Chinese firms are not flooding the U.S. market with goods, displacing U.S. workers in the process. Rather, foreign firms are increasingly leveraging low-cost China to their competitive advantage.
Take the iPhone, for example. While final assembly of the iPhone X by contract manufacturers occurs in China, the parts are sourced from a wide range of suppliers around the world. Touchscreens from Japan, memory chips from South Korea and Japan, and other components from the U.S., Europe and Taiwan make up the bulk of the component costs, while the final assembly done in China represents just 3% to 6% of the total manufacturing cost. With total materials costing $370 versus a $999 price tag for consumers, the bulk of the profits flow to Apple, yet the product—and many others like it— bear the familiar “Made in China” logo and shipments to U.S. consumers count as Chinese exports to America.4
Fifth, the U.S. trade deficit with China is a dangerous scorecard.
Much has been made of China’s trade surplus in goods with the U.S., which topped $375 billion in 2017. That’s a large figure, to be sure, but it does not accurately reflect the true nature of bilateral commerce between the two nations. Local sales of goods and services by U.S. foreign affiliates operating in China are missing from the equation. These sales totaled $307 billion by our estimates—well above the U.S. exports of goods and services to China ($188 billion) in the same year. In 2017, U.S. goods exports were $130 billion. In terms of trade in services, the U.S. actually posted a trade surplus with China, with exports of $58 billion and imports of $17 billion, according to Bureau of Economic Analysis.
Against this backdrop, the trade figures alone—the favorite benchmark of global commerce— underreport and misrepresent the true balance of commerce between the U.S. and China. The primary means by which U.S. firms deliver goods and services to China is missing from the debate. China does sell more to the U.S., but not by the lopsided margin some might suppose.
Sixth, capital remains China’s top export to the United States.
While the mainland’s exports to the United States run the gamut from Barbie dolls to footwear to computers, China’s most important export to the United States may be capital. Or more to the point: U.S. dollars.
Lost on many legislators in Washington is this simple yet critical fact: China not only provides U.S. consumers with low-cost, high-quality goods, it also provides the capital to purchase such goods by recycling greenbacks earned from trade back into U.S. Treasuries and other dollar-denominated assets. China remains the largest holder of U.S. Treasury securities, holding some $1.2 trillion as of June 2018.5 Should the United States opt to escalate its trade conflict with China, it may be cutting off a key source of foreign capital— something the world’s largest debtor nation can hardly afford.
Finally, the mainland remains an unlikely source of U.S. profits.
The lopsided nature of U.S.-Sino trade gives the impression that all the benefits go to the Chinese. We believe that is simply not true. One of the best-kept secrets on Wall Street is that U.S. firms are making tidy sums of money in the Middle Kingdom.
Data on foreign affiliate income from the BEA corroborate these findings. U.S. foreign affiliate income in China rose from $1.2 billion in 2000 to $13.4 billion in 2017. Affiliate income jumped 11% from the year before. China is among the most profitable emerging markets in the world for U.S. companies. Add U.S. affiliate income earned in Hong Kong, and the total is double the earnings of U.S. affiliates in Germany and France, combined.
The bottom line: These many strategic linkages between the U.S. and China require close attention on the part of investors. While some may associate China’s large and growing trade surplus in goods with the U.S. as a key competitive advantage for China, there are several other modes through which global companies reach consumers, including sales abroad by their foreign affiliates. What’s more, U.S. multinationals’ operations abroad are diverse, with China representing a small share of corporate America’s outward direct investment. These factors underscore the dynamism and competitiveness of U.S. companies and may help explain the resilience of U.S. large cap stocks despite ratcheting trade tensions between the U.S. and China.
1 Source: American Chamber of Commerce in China, “Impact of U.S. and Chinese Tariffs on American Companies in China,” September 13, 2018.
2 Source: Bureau of Economic Analysis. Data as of September 2018.
3 Peterson Institute for International Economics, “Trump Tariffs Primarily Hit Multinational Supply Chains, Harm U.S. Technology Competitiveness,” May 2018. Data for 2014.
4 Source: IHS Markit. Data as of November 2017.
5 Source: U.S. Department of the Treasury.